The affluent investor’s harsh RRSP reality

The failure to recognize this deferred liability can play havoc with retirement planning.

When affluent investors make their RRSP contributions, three financial events occur simultaneously. First, they are adding to their retirement investment capital. Second, they are creating a deduction that will reduce the tax they would otherwise be required to pay. So far so good! Building long-term assets and cutting taxes are both positive.

It’s the third event that most investors ignore. With every contribution, an investor is concurrently creating a deferred tax liability that will have to be paid sometime in the future. Over time, this deferred tax liability can grow to a staggering sum, running into hundreds of thousands or even millions of dollars as the RRSP grows.

Yet, in over thirty years as an advisor, I’ve met only a handful of investors who recognize this liability by explicitly carrying it on their balance sheet or seriously considering it in their retirement planning.

The present value of the stream of future taxes associated with the RRIF withdrawals or annuity payments should be recognized today as a liability.

The sad truth is that an RRSP is not a vehicle for permanent tax savings. Before the end of the year in which the RRSP account holder turns 71, the RRSP must either be converted to a Registered Retirement Income Fund (RRIF), used to purchase an annuity, or taken as a lump sum payment.

Since the lump sum payment is immediately taxable (and typically at a high marginal rate), the RRIF and the annuity are the only practical options for an affluent investor. In both cases, the subsequent annual mandatory RRIF withdrawals and the annuity payments must be included in taxable income and trigger taxes.

The present value of the stream of future taxes associated with the RRIF withdrawals or annuity payments should be recognized today as a liability.

The failure to recognize this deferred liability can play havoc with retirement planning.

Take, for example, two individuals both aged 72 and both with $2 million in assets. Assume, for illustration’s sake, one investor has no RRIF and holds all of these assets in a non-registered investment account while the other has all their capital in a RRIF set up after 1992. The RRIF investor faces a minimum obligatory withdrawal of 7.48% of the $2 million creating $149,600 in taxable income.

Although it varies by province of residence, the tax bill associated with this withdrawal is roughly in the range of $50,000.

Meanwhile, the non-registered investor can fashion an asset mix and select investments to dramatically reduce their investment taxes.

By focusing on tax-deferred capital growth, lower taxed capital gains and Canadian dividend income as well as possibly using tax-advantaged vehicles such as corporate class mutual fund shares, the tax bill could easily be a quarter of the $50,000 paid by the RRIF investor – leaving a stunning difference in after-tax retirement cash flows.

For the affluent RRIF investor aged 72, this is only the start of a painful annual ritual of confiscatory tax payments.

Each year, the minimum withdrawal requirement climbs reaching over 10% at age 85 and for the long lived, 20% at age 94. It is only the depletion of the RRIF itself that alleviates the problem. And unfortunately for conservative investors, today’s low interest rates will only accelerate the pace of this erosion as the returns of bonds and GIC’s within the RRIF itself will be muted.

Investors need to recognize the deferred tax liability associated with an RRSP when it arises – at the time of each contribution, and pre-fund it. In fact, the easiest source of that funding is the tax savings associated with the RRSP contribution itself.

By amassing considerable investment capital outside the RRSP, high net worth investors can cushion their retirement funds from the inevitable painful jump in taxes triggered by RRIF withdrawals or annuity payments.

Unfortunately, many individuals happily consume these tax savings every year while blithely ignoring the mounting tax liability they’ll face when it comes time to pay the piper. That’s a shame – it’s no fun later in life to watch your tax bills grind your retirement plans into the dust.

Michael Nairne CFP, RFP, CFA is the president of Tacita Capital Inc, a private family office and investment-counselling firm in Toronto. tacitacapital.com.

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